Fiscal Policy Basics

Government Spending

Discretionary Spending: The government chooses to do it.

Automatic Spending/Stabiliser: The government has no choice to pay, such as interest on debt, and benefits (e.g. law insures unemployment benefits).

With benefits they are automatic at any given moment, they become discretionary when the government changes policy, and creates new law. This would affect the level of automatic spending.

Taxation

Direct: It is taxation on income, which an individual is obliged to pay, such as income tax.

Indirect: This is done on the basis of consumption, the more you consume the more tax you pay. So in a sense the individual “chooses” to pay it. This can take the form of VAT, sales tax, etc.

The main factors can be classified as injections and withdrawals

Injections

  • Government Spending
  • Exports
  • Loans (increased amount of investing)

Withdrawals

  • Tax (indirect or direct)
  • Imports
  • Savings (ISA, IISA, etc.)

Expansionary Fiscal Policy

This is fiscal policy which is designed to expand the output of an economy. This can be done through increasing aggregate demand, or increasing aggregate supply.

The simplest manner of achieving this is from “spending more, taxing less”. Spending can take the form of government spending, or increasing loans and investments. Increasing exports can also be seen as expansionary.

It is necessary to keep factors such as tax, imports, and savings to a minimum to insure increased economic activity.

Contractionary Fiscal Policy

This is a fiscal policy which is designed to reduce the output of an economy. This is in order to “cool-off” an economy that is overheating (i.e. too much economic activity, pushing inflation rate over a sustainable level).

The simplest manner to do this would be to cut government spending, raise interest rates (make borrowing more difficult), and decrease exports. This would lead to a decline in economic activity. More withdrawals can also be made through encouraging personal savings, increasing tax, and imports.

An example of expansionary occurring would be an outwards shift in aggregate demand, and an example of contractionary occurring would be an inwards shift in aggregate demand. This would determine price levels, and the output of an economy.

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